February 20, 2007

A Good Word for Hedge Fund Activism

Here is an article from Sunday’s NY Times: When hedge funds buy shares of a company and start agitating for changes in the way it is being managed, they may seem to be gunning for a quick killing at the expense of longer-term shareholders.

But, in fact, the evidence shows that for the most part, buy-and-hold investors ought to cheer when hedge funds jump aggressively into a stock, according to a new study. Titled “Hedge Fund Activism, Corporate Governance and Firm Performance,” it was written by Alon Brav, a finance professor at Duke; Wei Jiang, an associate professor of finance and economics at Columbia; Frank Partnoy, a law professor at the University of San Diego; and Randall S. Thomas, a professor of law and business at Vanderbilt. The study has been circulating in academic circles since the fall.

The authors examined nearly 900 instances from 2001 through 2005 of what they call hedge fund activism. The professors compiled their database in large part from the reports that hedge funds must file with the Securities and Exchange Commission whenever they acquire at least 5 percent of a company’s outstanding shares and intend to get involved in running the company.

Though the professors concede that they have no way to know whether their sample included every instance over this five-year period of hedge funds trying to change a company’s behavior, they write that they believe the sample “includes all the important events.” Included in the professors’ database are not only aggressively hostile actions like threats of lawsuits, proxy fights and takeovers, but also offers to help management enact policies intended to bolster the company’s stock price. Inherent in such cases, Professor Brav said, is an implied threat of hostile actions if management rebuffs those offers.

The professors found that the stock of the average company singled out by a hedge fund outperformed the overall market by 7 percentage points over a four-week period: the two weeks before and the two weeks after the hedge fund’s public acknowledgment that it was aiming at the company. Why would a stock start moving two weeks before the public announcement? One possible factor, Professor Brav said, is heavy buying by the hedge funds. After all, hedge funds have two weeks after obtaining a 5 percent stake in a company to report their ownership stake in a public filing.

If hedge funds did nothing to improve the target company’s profitability, this short-term boost to its stock price would be temporary, and the stock would fall back. But that is not what the professors found.

In the year after that initial month of market-beating performance, the average target company’s stock kept pace with the overall market. And over the subsequent two years, the professors also found, the operating performance of the target companies improved markedly.

As an example, Professor Brav referred to the continuing efforts of Pirate Capital, a hedge fund, to raise the stock price of Walter Industries, a widely diversified industrial company. In May 2005, Pirate Capital indicated in a public filing that it had acquired more than 5 percent of the company’s shares. In a letter sent that month to Walter Industries’ management, Pirate Capital made a number of proposals that it said would bolster the company’s stock, like spinning off certain of its divisions. The hedge fund indicated that, if management refused to act on the proposals, it would try to elect new directors at the next shareholder meeting. In the nearly two years since then, the management of Walters Industries has put into effect many of Pirate Capital’s proposals, and the stock price has outperformed that of the average stock in its industry.

In finding that the market’s reaction to this type of activism was the rule, not the exception, the professors concluded that the average long-term investor in companies singled out by hedge funds has benefited significantly. Because only a little over a year has passed since the end of his sample period, Professor Brav conceded that it was theoretically possible that the companies singled out by hedge funds would be worse off over the longer term. But he asserted that the data compiled for the study provided little support for this possibility, and that he thought it was unlikely.

The professors also examined whether hedge funds that try to change corporate behavior typically focus more on the short term or the long term. They found that in nearly half the cases they studied, the hedge fund still owned a large stake in the target company in October 2006. And in those cases when the hedge fund had sold its stake, the average holding period was close to one year. From this evidence, the professors conclude that “activist hedge funds are not excessively short term in focus.”

“Hedge funds provide an example of effective shareholder activism,” Professor Brav says. He noted that “when other institutional investors engage in activism — such as pension funds or mutual funds — they typically have not been effective in improving firm performance.”

Given this new research, it makes sense for investors to pay close attention to the holdings of activist hedge funds. One approach, of course, would be to buy stock of a target company immediately after a hedge fund notifies the S.E.C. that it has acquired at least a 5 percent stake, with the intention of getting involved in running the company. Professor Brav cautions that such a stock will have already begun to outperform the market by the time an investor buys it. But if the pattern in the study holds, that stock should also continue outperforming for at least a couple of more weeks.

As more investors jump into the target companies, however, beating the market this way could become more challenging.